One of the biggest narratives behind why the stock market just went haywire is wrong

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• This week’s sell-off has been linked with and blamed on interest rates, with investors said to have become concerned about higher US inflation.
• Strategists at Pavilion Global Markets and elsewhere say this dominant narrative is incorrect.
• As equity volatility spiked, rates markets stayed stable.
• Risk-parity funds, which invest in a combination of stocks and bonds based on factors including volatility, may have contributed to the sell-off as stock market fear increased, Pavilion said.

Rising interest rates are near the top of virtually every story out there explaining why the stock market fell this week, given that the sell-off gained speed Friday after the jobs report showed that average hourly earnings rose year-on-year at a pace not seen since 2008 — a sign inflation was picking up.

But equity strategists at Pavilion Global Markets disagree with that narrative.

They don’t discount the relationship between bonds and stocks, specifically, how higher interest rates weaken the relative valuation of stocks.

But in a note Wednesday, they also laid out a few reasons this was not a rate-induced sell-off. Their arguments line up with other strategists’ who have pointed to the unwinding of a popular short-volatility trade and computer-induced selling as bigger drivers of the sell-off — especially as the Dow lost more than 1,000 points in late-Monday trading.

If the sell-off were truly rate-driven, “we would have seen the interest rate-sensitive sectors underperform broader equity indices severely, which was not the case,” Pavilion wrote. “Utilities and consumer staples actually outperformed during the selloff.”

The two S&P 500 sectors, which can be hurt by higher interest rates, were only the sixth- and ninth-worst performers out of 11 from Thursday through Tuesday.

Of course, the apparent concern was not inflation alone but rather how the Federal Reserve may respond. The theory is that higher wages would increase demand and prompt companies to protect margins by raising prices, both of which are inflationary, causing the Fed to raise rates. But even on that point, Joseph Lavorgna, the chief economist of the Americas at Natixis, cautions that higher wages don’t necessarily translate to higher inflation.

He said in a note Wednesday that the Federal Reserve chair, Jerome Powell, “would be wise to resist the temptation to aggressively raise rates in the face of falling unemployment and modestly higher wages.”

Lavorgna included this chart, which shows that core personal consumption expenditures — the Fed’s preferred way to gauge inflation — doesn’t always have a direct relationship to wages.

Natixis

Equity volatility didn’t spread

Derivatives strategists at Bank of America Merrill Lynch echoed this point. In a note on Tuesday, they highlighted that while the Cboe Volatility Index, or VIX, saw its biggest one-day spike ever, the rates market remained rather calm. What this sell-off was really about, they said, was exposing the fragility of strategies who bet against volatility and are now at risk of being wiped out.

“While many suggest this shock was driven by concerns of inflation leading to faster than expected policy normalization (the right thing to be concerned about in our view), rates have been incredibly stable compared to past bond-led shocks such as the taper tantrum,” a team including Benjamin Bowler said.

Bank of America Merrill Lynch

“In fact, Treasuries rallied Monday in a flight-to-quality (perhaps aided by CTA positioning), but the fact this shock so far is very equity centric is positive,” they added. “Key to understanding whether this is a short-term technical equity sell-off, which quickly reverses, or the beginning of something bigger, lies in where rates vol goes from here.”

Pavilion additionally looked into the risk-parity strategy, which distributes investments across asset classes based on their volatility.

It found that these funds increased their equity allocations since 2016, helping them weather some of the volatility in fixed-income losses that were associated with inflation concerns. But that made the strategy cyclical, in that these funds shed stocks as volatility rose.

Pavilion said: “If there is a deleveraging of the risk parity strategy in the wake of higher realized and implied volatility assumptions, the increase in allocations to equities has made equity markets more vulnerable to sudden selling by these types of funds via a self-reinforcing mechanism.”